GAAP Rules and Accounting Fraud

Purpose:

Learn how failure to follow GAAP Rules and Accounting Fraud go hand-in-hand in a $7.4 billion scandal.    

Welcome Message:

My name is Steve Hart, and I am a contributing journalist for Compliance Mitigation.  I am a Partner at Conformity 360, a compliance consulting firm, serving as the resident subject matter-expert in buy-side Compliance. Prior to joining Conformity360, I was Chief Compliance Officer (“CCO”) for the prestigious firm Allen & Company, and prior to that, served as the Global Chief Administrative Officer for Compliance at BlackRock, the world’s largest asset management company.  I hold an Investment Adviser Core Certification, an M.S. in Banking and Financial Services from Boston University and a B.A. in Political Science from the University of Pennsylvania. 

Having worked as the CCO for Registered Investment Advisers (“RIAs”) with the Securities and Exchange Commission (“SEC”), I have been through numerous regulatory audits and examinations.  Experience gives me insight into how the regulatory bodies conduct investigations and attempts to obtain enforcement actions, often including jail and prison sentences. 

Objectives:

After completing this case study, the participants will be able to:

1. Define the concept of Accounting Fraud.
2. Define what it means to be GAAP Compliant.
3. Understand the irreparable harm done to a company that engages in Accounting Fraud.
4. Understand what prompts regulatory bodies and law enforcement to initiate investigations and bring criminal charges pertaining to Accounting Fraud.  
5. Identify activity to avoid that might facilitate Accounting Fraud, and potential criminal liability.

Common Terms:

Accounting Fraud, Company Earnings, GAAP Compliance, Backdating, Shareholders’ Equity

Current State:

Accounting Fraud is the “illegal alteration of a company’s financial statements in order to manipulate a company’s apparent health or to hide profits or losses.”  Several of the most common methods for committing accounting fraud include overstating revenue, failing to record expenses, and misstating assets and liabilities, but there are many more.

To elaborate, accounting scandals arise from intentional manipulation of financial statements with the disclosure of financial misdeeds by trusted executives of corporations or governments. Such misdeeds typically involve complex “methods for misusing or misdirecting funds, overstating revenues, understating expenses, overstating the value of corporate assets, or underreporting the existence of liabilities (this can be done either manually, or by the means of deep learning).” It involves an employee, account, or corporation itself and is misleading to investors and shareholders. 

This type of “creative accounting”, as some refer to it, can amount to fraud and often lead to investigations typically launched by government oversight agencies, such as the SEC. The Department of Justice may also bring criminal indictments against individuals for engaging in such errant behavior.

Future State:

Individuals who commit Accounting Fraud expose themselves to personal criminal prosecution. It makes no difference if such action is taken at a person’s own discretion or at the direction of an employer. In the latter instance, the law will hold both individuals accountable as part of a conspiracy. Even more unnerving, employers may be held liable for the actions of underlings if and when investigators determine the employer should have known about the violation. Such actions additionally impose liability on the company itself, for not having the proper internal controls in place.  

Recent scandals have begun to reignite the debate over the relative merits of US GAAP, which takes a “rules-based” approach to accounting, versus International Accounting Standards and UK GAAP, which takes a “principles-based” approach. The Financial Accounting Standards Board intends to introduce more principles-based standards, recognized as much less susceptible to manipulation. Even more radical means of accounting reform have been suggested as well.  

Real debate concerns concepts such as whether to report transactions, such as asset acquisitions, at historic cost or at current market values. “The former, traditional approach, appeals for its reliability, but can quickly lose its relevance due to inflation and other factors; the latter, increasingly common approach, is appealing for its relevance, but is less reliable due to the need to use subjective measures.” Accounting standards setters such as the International Accounting Standards Board attempt to strike a balance between relevance and reliability.

Situation:

A major international retailer of furniture and household goods based out of South Africa finds itself in difficult financial straits. Management elects to begin covering up shortfalls in income, in cahoots with certain third parties, by manipulating books and records to reflect results significantly better than achieved by the company. The practice continues to grow as the hole gets deeper, until finally discovered by a special report from an independent auditor.   

Background:

Steinhoff International (“Steinhoff”) is a South African international retail holding company that deals mainly in furniture and household goods. It operates in Europe, Africa, Asia, the U.S., Australia and New Zealand. The company did over $15 billion in sales for calendar year 2019.

In 2017, senior executives became suspicious of some irregular activity in the company’s financial reporting activities. They hired the internationally recognized accounting and consulting firm PwC (“PwC”) to conduct a special audit. PwC completed a 3,000-page report confirming the suspicions of senior management but to a much greater degree than they imagined.

The report revealed irregular transactions totaling 6.5 billion euros ($7.4 billion) from the year 2009 through 2017, conducted by a small group of former Steinhoff executives and individuals from outside the company in South Africa’s biggest corporate scandal. These former Steinhoff executives and individuals from outside the company, led by an identified “senior management executive,” implemented deals, which substantially inflated the group’s profit and asset values.

“The transactions identified as being irregular are complex, involve many entities over a number of years and are supported by documents including legal documents and other professional opinions that, in many instances, were created after the fact and backdated,” Steinhoff said.

Police in South Africa have been anxiously waiting for the results in this PwC report and indicate an intention to bring significant charge against those involved with committing the fraud.  

Steinhoff has yet to name the individuals involved but states the company does not continue to employ them. A company spokeswoman declines to give further details.

Analysis:

The scandal completely wiped-out significant Shareholders’ Equity and led to several resignations including chief executive Markus Jooste, who is instrumental in putting Steinhoff on investor radar screens. Jooste, who denies any wrongdoing, has not yet made himself available for questioning by PwC investigators. 

The scandal caused Steinhoff’s publicly traded shares to crater, as the company wrote down the value of its assets by more than $12 billion after PwC provided a copy of its initial findings. There may be more write-downs to come. The company’s market valuation dropped an incredible 216 billion Rand in the past three years as a result of the scandal, a dramatically sad turn of fortunes for a company that was “once a must-have in fund managers’ portfolios.”

Steinhoff says the PWC report found that top management figures entered into “fictitious transactions” with entities purported to be independent third parties to create the illusion of income used to hide losses at the company’s operating units.

While the company does not name the individuals or business units involved, it does specifically note that they did not include two European subsidiaries, Pepkor Europe and Poundland, or any of its African units, which include Pepkor Holdings.  

The full financial impact of the findings is still being determined, as is the legal impact and criminal consequences. It’s safe to say, however, that a number of people will be facing serious prison time as a result of their actions.

Recommendations:

Financial accounting information must be assembled and reported objectively.  For this reason, financial accounting relies on certain accounting best practices and standards called Generally Accepted Accounting Principles (“GAAP”).  

GAAP principles form the principal starting point of every companies’ internal compliance program. Companies must also, however, impose internal policies and controls to ensure that GAAP is adhered to. $7.4 billion is a considerable sum of money, even spread out over the eight-year period of the scheme. A company with a robust compliance program would have picked up on this scandal much sooner, its $15 billion in annual revenue notwithstanding.         

As for GAAP compliance, it derives from tradition. In any report of virtual accounting information (audit, compilation, review, etc.), the preparer/auditor must indicate whether or not the information contained within the statements complies with GAAP. It provides a clear and important baseline standard for presenting and understanding the financial condition of a company. Failure to comply with GAAP, whether unintentionally or on purpose, materially misrepresents the financial condition of a company and causes serious financial hardship to those who rely on the misrepresentations. Companies must both rigidly adhere to GAAP and ensure that proper internal controls exist to ensure compliance.   

A general list of GAAP compliance principles follows:

• Principle of Regularity: Regularity is defined as conformity to enforced rules and laws.

• Principle of Consistency: The consistency principle requires accountants to apply the same methods and procedures from period to period.

• Principle of Sincerity: According to this principle, the accounting unit should reflect in good faith the reality of the company’s financial status.

• Principle of The Permanence of Methods: This accounting principle aims to provide coherence and allow comparison of the financial information published by the company.

• Principle of Non-Compensation: One should show the full details of the financial accounting information and not seek to compensate a debt with an asset, a revenue with an expense, etc.

• Principle of Prudence: This accounting principle aims to show the reality “as is” — one should not try to make things look prettier than they are. Typically, revenue should be recorded only when it is certain and a provision should be entered for an expense which is probable.

• Principle of Continuity: When stating financial information, one should assume that the business will not be interrupted. This accounting principle mitigates the principle of prudence — assets do not have to be accounted at their disposable value, but it is accepted that they are at their historical value.

• Principle of Periodicity: Each financial accounting entry should be allocated to a given period, and split accordingly if it covers several periods. If a client pre-pays a subscription (or lease, etc.), the given revenue should be split to the entire timespan and not counted for entirely on the date of the transaction.

• Principle of Full Disclosure/Materiality: All financial accounting information and values pertaining to the financial position of a business must be disclosed in the records.

Sources:

• https://www.fraud-magazine.com/article.aspx?id=4294994026
• https://www.accountingdepartment.com/contact-your-virtual-accounting-department
• https://www.fraud-magazine.com/topics.aspx?topic=cases
• https://www.theglobeandmail.com/report-on-business/supreme-court-says-livent-auditors-liable-but-sets-conditions/article37393018/
• https://www.iasplus.com/en-gb/standards/other/framework